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Should You Add Inflation Protection to Your Portfolio?

An unpredictable market, rising fuel prices, and growing concern that inflation may trend higher as the economic recovery takes hold.

These are three good reasons to add inflation protection to your portfolio, says Mario DeRose, fixed income strategist with Edward Jones in New York.

“There’s always a place in a portfolio to hedge against inflation, even in periods when inflation seems unlikely in the near term,” says DeRose, noting that shocks in the market can cause consumer prices to spike without warning. “You have to be on guard.”

Enter: Treasury Inflation-Protected Securities, or TIPS.

TIPS are government bonds issued by the U.S. Treasuryin maturities that range from five to 30 years.

Unlike conventional bonds, TIPS pay out a guaranteed “real” return; the principal is adjusted for inflation based on the Consumer Price Index, CPI, and semi-annual interest payments (the yield) are modified accordingly.

At maturity, investors receive either the inflation-adjusted principal or par value, face value, of the bond, whichever is greater.

As such, TIPS are used to hedge inflation, helping investors maintain purchasing power when the price of goods and services climbs, with the added benefit of providing downside protection during periods of deflation.

Such securities have served investors well over the last few years, as falling interest rates push bondprices higher.

The Barclays Treasury Inflation Protected Securities index, for example, produced a total return (which consists of the bond’s income distributions plus any appreciation or depreciation in the price of the bond itself) of 13.6 percent in 2011, 6.3 percent the year before, and 11.4 percent in 2009. It is up roughly 2.5 percent this year.

The total return for the SPDR DB International Government Inflation-Protected Bond ETF, is also up roughly 8 percent year-to-date.

By comparison, conventional 10-year Treasury bonds returned 17 percent last year and 8.1 percent in 2010, on the heels of a nearly 10 percent loss in 2009.

Negative Yields

Due to demand from wary investors, however, the yield on TIPS is in negative territory; for 10-year TIPS the interest payments are hovering at negative 0.4 percent.

Those buying today are willing to accept a negative yield because they believe inflation is likely to rise enough to compensate for the loss they’re locking in and because they seek the safe haven that government backed bonds provide, says Christine Benz, director of personal finance for fund tracker Morningstar.

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Though they’re not the “screaming buy” they were in late 2008 and 2009, she notes, TIPS still play an important role in portfolio planning — particularly for retirees who feel the loss of buying power associated with higher inflation disproportionately.

“Retirees need to be sure they have adequate inflation protection, because they’re not getting cost of living adjustments anymore through paychecks at work,” she says. That, plus the fact that healthcare costs are climbing even faster than the overall rate of inflation, she says, makes higher prices harder to absorb.

CAUTION: Inflation Ahead

By most accounts, inflation is not a significant threat for 2012. (Though rising gas prices in January did give the CPI its biggest bump in four months.)

But David Darst, chief investment strategist for Morgan Stanley Smith Barney, says that could change if the Federal Reserve takes additional steps to jump start the lackluster economy.

“Like everyone else, we don’t see inflation as a big overriding concern right now, but we are worried about it longer term,” he says, noting that TIPS and TIPS funds are a “little rich” at present.

Mihir Worah, managing director of PIMCO investment firm, which specializes in fixed income securities, also notes in his 2012 Inflation Outlook report that the firm is taking a longer term bias “toward higher inflation.”

“Faced with this possibility of higher inflation, many investors may need to examine their allocations to assets associated with real return potential, including Treasury Inflation-Protected Securities, TIPS, real estate, commodities and equities,” he writes.

You can purchase TIPS, which are traditionally less volatile than other inflation hedges like commodities and currencies, directly from the U.S. Treasury.

Investment Options

But many opt for mutual funds and exchange traded funds, ETFs, that invest in inflation-protected securities.

The advantage of TIPS funds is that many hold TIPS with varying maturities, which can help diversify your bond exposure. They also allow investors to automatically reinvest the income they earn.

For “cheap” and “plain vanilla” TIPS funds, Morningstar recommendsiShares Barclays TIPS Bond Fund and Vanguard’s Inflation-Protected Securities Fund, along with PIMCO’s actively managed Harbor Real Return Fund .

Because of the negative yield, however, Benz suggests dollar cost averaging into the position, or buying smaller increments over a period of six months to a year, rather than investing in TIPS as a lump sum.

“The typical investor’s portfolio probably doesn’t have enough inflation protection, but it seems like a good idea to tiptoe in rather than buying a huge chunk of TIPS at this juncture,” she says.

Another note: TIPS, are exempt from state and local tax, but because you’ll owe federal taxes on the interest income, they are best held in tax-sheltered retirement accounts, says Benz.

As an alternative, she adds, iBonds and certain target-date mutual funds, which are designed to become increasingly conservative as investors approach retirement, can also provide an element of inflation protection, noting Vanguard’s Target Retirement Income has about a third of its fixed-income portfolio in a TIPS fund.

I-Bonds are savings bonds issued by the U.S. Treasury.

Its rate adjusts to track inflation and is guaranteed to never lose value, but they only pay income when you sell so you won’t be getting an income stream as you would with TIPS.

I-Bonds also come with an income limit of $10,000 per person per year (and likely to go lower), which can be a drawback for those looking to insulate their portfolios sufficiently against inflation, says Benz.

How Much Should You Own?

It depends on your time horizon and appetite for risk, of course, but DeRose suggests an allocation of 5 percent to 10 percent in TIPS should be “more than enough protection” for the average investor.

Darst says a moderate high net worth investor may want less, somewhere on the order of 3 percent, while a more conservative investor can err higher, in the 6 percent to 8 percent range.

He notes the secret to building a well-balanced portfolio is being prepared for whatever the market may deliver.

“It’s important to educate yourself on what TIPS are and how they work today, rather than waiting until after inflation picks up,” says Darst.

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